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May 04, 2007

HUI/Gold Ratio Trends
by Adam Hamilton

As we continue our fascinating journeys of discovery as students of the markets, we do a lot of charting work at Zeal. Recently a chart that I hadn't given much thought to for the better part of 8 months caught my attention again. It was a HUI/Gold Ratio chart, also known as HGR in this essay.

The HUI/Gold Ratio is as simple as it sounds, it is calculated by merely dividing the daily close of the HUI unhedged gold-stock index by the daily close in the price of gold. When this resulting ratio is graphed over time, it vividly illustrates the ever-shifting relative strength of the gold stocks versus gold. As their bulls mature, one is stronger and then the other, back and forth. They are engaging in a great secular tug-o-war.

At times the gold stocks are thriving, rising much faster than their golden underlying primary driver, so the HGR rises. At other times much like what we've witnessed so far this year, the gold stocks are languishing in consolidation mode so gold has the chance to rise faster than them and thus drive the HGR lower. Over time this evolving dynamic carves some interesting chart patterns.

In the early years of this bull, a friend of mine came up with an elegant trading system for actively trading the gold stocks based on the HGR's technicals. Like most trading systems, it was very successful for years but then its efficacy started to fade. Prior to 2005 its buy and sell signals were rare and useful, but later that year the wild HUI made them start to thrash. With buys and sells happening constantly, this system's utility waned. I discussed the limitations of this particular HGR trading system last year.

After that experience, my focus drifted away from the HGR. But last month as I was updating some of the charts in the subscriber chart section of our website, the secular trend of the HGR caught my eye. It looked like a long-term trend channel had emerged in this indicator and that it was nearing the place where gold stocks started to really outperform gold in the past, or a major HUI buy signal.

So is the venerable HUI/Gold Ratio once again suggesting that a major gold-stock upleg is drawing nigh, that gold stocks are due to outperform the metal they mine? Yes, it sure is. And considering how horribly dismal the HUI sentiment has been so far this year, a ray of hope shining in from the HGR is certainly most welcome.

Here is a smaller essay-sized version of the chart that caught my attention. Note the well-defined secular uptrend channel rendered below, which shows that the HUI has been rising faster than gold on balance for many years now. Also note that the HGR is once again near the lower support of this trend channel today. Each time in the past this happened, soon after the HGR soared as a mighty HUI upleg launched.

The HGR is the blue series in these charts, with accompanying key moving averages. It is superimposed over the raw HUI itself, shown in red. Not surprisingly, when the underlying HUI shoots higher in a mighty upleg, it rises much faster than the gold price and hence drives the HGR heavenwards. And the beginnings of such hugely profitable major HUI uplegs in recent years have occurred at HGR support.

The HGR secular support line shown here is well-defined. The HGR bounced off it decisively in mid-2002, early 2003, and mid-2005. In each case the HUI surged sharply after its HGR support approach. And today the HGR is once again converging to this same support line that has been so bullish for the HUI so far in its bull market to date.

And interestingly a top resistance line perfectly parallel to the lower support is also readily evident in this chart. At the end of major uplegs, the HUI would get ahead of itself and correct, falling faster than gold which leads to gold's relative outperformance which drives the HGR down. While there was a massive above-resistance surge in late 2003, this parallel resistance line held strong in mid-2002, late-2004, and early 2006.

So the complex and often tactically chaotic interrelationship between the gold stocks and the metal that drives them can be distilled down into a simple technical uptrend! The strength and potency of any trend channel is directly proportional to the number of years that it has remained in place. With this uptrend starting way back in 2002 and showing no signs of failing yet, odds are it is pretty important to consider.

Its simple message today is buy gold stocks because they are probably on the verge of a major upleg. When the HUI performance has been bad for so long that the HGR is driven down to support, a period of gold-stock outperformance is once again due. We are very near such a critical bullish inflection point today.

This is very exciting, but as a lifelong student of the markets I am usually more interested in why particular trading signals work rather than just trading blindly on their mere existence. So the logic underlying this HGR secular uptrend, and the alternating cycles of gold then gold-stock outperformance, is very intriguing to me. Having pondered this question for some weeks now, this pattern makes sense.

All financial markets are driven by never-ending sentiment waves. These waves are the collective sum of traders' emotions regarding a particular sector. Their crests are driven by greed, euphoric times when new highs are being carved and traders think prices will never stop rising. Then inevitably the troughs driven by fear follow, dark times in the bowels of major corrections when traders think prices will never quit falling. All tactical price action is ultimately the result of aggregate popular greed and fear.

Gold stocks and gold certainly aren't immune to these sentiment waves. In fact, given the incredible gold-lust that burns deep within virtually all the hearts of men, gold's reactions to collective greed and fear are often magnified. There is an old market aphorism stating "there is no rush like a gold rush", and history certainly validates it.

Although there are separate sentiment waves echoing through both gold and gold stocks, for a couple reasons gold's usually steer both sets. First, the gold price is much more fundamentally-driven than the stocks. Gold's annual mined supply is very finite, and nothing can rapidly speed its growth due to the difficult and time-consuming nature of this industry. So gold's price should be closer to fundamentals than stock prices most of the time, and far less noisy.

Stocks, ultimately, are just paper. While they do represent fractional ownership in real gold mines, existing companies can issue new shares at will and new companies can form at any time and float stock. Both of these events add to existing gold-stock supply. While gold supply growth is ironclad finite, theoretically there are no limits on gold-stock supply growth. This means gold-stock prices are not as fundamentally absolute as gold's and hence more susceptible to tactical sentiment-driven anomalies.

Second, gold is the ultimate driver of gold-stock prices. Gold miners mine gold, so higher gold prices lead to higher profits. The stock markets eventually reward higher profits by bidding up stock prices to reflect them. And there is a psychological element here too. Gold-stock traders are most likely to buy gold stocks when gold is rising. So climbing gold is the primary catalyst for bullish gold-stock action, leading gold to influence gold stocks and not the other way around.

Although gold is being driven relentlessly higher on balance by fundamentals, its path is not arrow-straight. Sentiment waves force gold to oscillate around its long-term uptrend, temporarily going above trend when traders get greedy and excited and temporarily going below when they get scared and worried. These sentiment flows and ebbs in gold largely drive the sympathetic yet amplified gold-stock sentiment waves.

When gold strength gets gold-stock traders excited, their capital floods into the relatively tiny gold-stock sector. Stock prices soar as they try to absorb the capital inflow. Eventually, as in all uplegs in all sectors, greed grows too great and all the traders who want to buy have bought. Then the inevitable correction arrives. The resulting trough of the sentiment wave brings selling and ultimately fear, and gold-stock prices are hammered.

I think these sentiment waves are what we are seeing in the chart above, the logical cause for a tight secular HUI/Gold Ratio uptrend channel carved over years. When the greed part of a wave arrives both HUI and gold rise but the stocks rise much faster since they have such a tiny collective market capitalization compared to the trillions of dollars worth of gold out there. This dynamic drives the HGR higher to its upper resistance line. These events are marked "surge" in this chart.

Then when the sentiment waves crest, gold and the HUI tend to peak within close temporal proximity of each other. Four of these peaking events, marking the ends of major HUI uplegs, are numbered above. Note that they generally occur at or above upper HGR resistance. Soon after when the trough of the sentiment waves follows, it manifests itself in parallel corrections in gold and the HUI.

But just as the HUI leverages gold's gains to the upside when greed is waxing extreme, it also leverages gold's losses to the downside. During the ebbing of the sentiment wave when the HGR is retreating, it is often not because gold is rising faster than the HUI but because gold is falling less fast than the HUI. This too represents gold outperformance relative to the HUI. These episodes are labeled "drift" above, and they drag the HGR back down to its support. We see this HGR surge, top, drift, bottom pattern over and over again.

Thus there seems to be a logical sentiment cause for the HUI and gold interaction that created the stunning uptrend in this chart. Since these waves hit with some regularity and tend to have similar amplitudes and durations, they are able to gradually flesh out a linear ascent. It is really fascinating to step back from the markets and try to understand sentiment and its effects from a strategic level!

Even with a probable cause outlined, the conclusion is the same. The HUI/Gold Ratio is near secular support because the fear trough of a sentiment wave is passing. Gold has outperformed the HUI for a year now, as evidenced by the falling HGR, but since the HGR is near support this episode is probably drawing to an end. In order for this cycle to continue and the HUI to outperform gold and drive the HGR up to resistance again, we are going to have to see another massive HUI upleg.

Although the regularly alternating episodes of HUI-then-gold relative outperformance driven by sentiment are the most intriguing part of this whole thread of research to me, the tactical HGR is also quite interesting. If we zoom into just the very right edge of the chart above, since gold's and the HUI's latest interim tops of last May, this latest drift is forming a tightening wedge. It is rendered here.

While this tactical wedge is not as well-defined as the secular uptrend, it is still quite apparent when drawn with best-fit lines. Interestingly it is symmetrical too, with its upper resistance representing the same slope, but inverted, of its lower support. This sideways action is technically a drift, a period of gold outperformance, but with the HGR trending flat neither the stocks nor the metal have pulled decisively ahead for a year.

This wedge pattern is getting ratcheted tighter and tighter the longer that gold and the HUI struggle for the outperformer crown. At the current wedge rate of convergence, it takes about two months for a 0.01 HGR increment to be cut out of the wedge. With the wedge point now trapped between roughly 0.51 to 0.54, this means that this wedge must mathematically break this summer and it will likely fail even sooner.

The big question is which way will the HGR go once its tactical wedge fails? Will the HUI outperform driving the ratio higher or will gold outperform driving it lower? Based on the bull-to-date precedent discussed above, I think the odds far favor the HUI outperforming gold so the HGR breaks out to the upside. Here's why.

Gold remains in a strong secular bull market for fundamental reasons. I discussed the very latest gold fundamental data in the new May issue of our monthly newsletter just published this week if you are interested. It is incredibly bullish! Gold's global mined supply is falling while its demand is rising, a sure recipe for higher prices. And if gold is still in a secular bull, then gold stocks will ultimately follow it higher.

As the history of the HUI/Gold Ratio clearly shows, periods of HUI outperformance alternate with periods of gold outperformance. Over this past year we've been in a drift phase, where gold was outperforming the HUI on balance. Thus we are due to reenter the other state where the HUI outperforms. This can only happen if a major new gold-stock upleg is on the verge of launching. So cycle probabilities favor the HGR breaking out to the upside.

This leaves one more exciting question. If a major HUI upleg is coming and it ultimately drives the HGR up to resistance again, how high could the HUI go? Well, based on the first chart the next HGR resistance intercept should be between 0.65 and 0.70. So let's use 0.68 as an estimate. And of course the level of the HUI at this secular resistance line depends on where gold itself tops.

If gold was merely to top at $700 when the greed-laden crest of the next sentiment wave passes, then a 0.68 HGR yields a potential HUI top of 475. This is 40% higher from here! Imagine how a portfolio comprised of elite high-potential gold stocks would perform if the HUI merely rises to 475. I suspect the ultimate upleg gains would be pretty awesome.

But odds are gold is not just going to stop at $700 in this upleg. The massive gold upleg that topped last May, gold's first Stage Two investment-driven upleg, soared about 70%. Back in Stage One, gold uplegs tended to run around 20% each. Using a conservative back-weighted average, let's assume gold will run 40% higher in this upleg. From its lows of this past October, a 40% gain would carry gold to $785.

At $785 and a 0.68 HGR resistance level, the HUI itself would have to soar to 535 or so! This is 55% higher from here. As always these exact target numbers aren't all that important, just the understanding that if the HUI/Gold Ratio sticks to bull-to-date precedent the next major interim high in the HUI should be far higher than today's levels. If such an upleg indeed materializes, traders riding it will win enormous profits.

At Zeal we have been preparing for this expected upleg since the October lows. We have deployed a bunch of gold-stock positions already, and are buying more on weakness. Some have been stopped out on the HUI's various pullbacks since then, but the survivors are thriving. This week even in the depths of the latest HUI pullback, we had unrealized gold stock gains running as high as 65% on individual stock trades.

If you are looking for cutting-edge research and analysis on not only timing major gold-stock uplegs but on finding the highest-potential gold stocks to buy to ride these uplegs, our acclaimed monthly Zeal Intelligence newsletter is for you. In it, as we have done in every HUI upleg since 2000, we research and recommend elite gold stocks when the technical timing to buy looks opportune. The profits so far have been great and should only grow as this bull matures. Please subscribe today and join us!

The bottom line is the HUI/Gold Ratio is approaching its long-term support. In this bull to date, each time this has happened the HUI has soared heavenwards soon after in a mighty new upleg. With gold's fundamentals still awesome, and gold driving this gold-stock bull, the odds favor the HUI soon outperforming gold again and surging higher to drive up the HGR as it has done in the past.

The HGR drift of the past year has been a trying one psychologically, but it has built the perfect foundation for a new upleg to launch. Not only is HUI sentiment still pretty pessimistic today, the contrarian time to buy, but it has built a new higher technical base from which to launch its assault on new highs. On top of all this it is technically due to start outperforming gold again in a cycle sense.

Adam Hamilton, CPA
Zeal LLC.com

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If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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